Subprime mortgage lending
Sub-prime lending refers to giving credit to persons who do not qualify for loans at prime rates (Muolo, 13). Mortgages and credit cards usage make up lending through sub-prime. Riskier sub-prime borrowers do not pay for their loans. An examination of financial institutions shows that they usually reimburse their accounts by charging more interest rates for mortgages. In the United States of America, sub-prime lending has increased over the years beginning 90s. This saw a rise in loans to an estimate of $1.3 trillion in relation to subprime mortgages. The increase in the number of loans followed an action by financial institutions to package mortgages in form of securities and subsequently sell them to investors. One of the reasons behind the packaging of these loans was the possibility of managing them, a factor that was further complemented by increasing house prices and the apparent steadiness of mortgage-backed securities. This only lasted for a short period of time. In the year 2006, the decline in the prices of homes resulted in losses as owners discovered that the amount they owed on mortgage was more than the value of their homes. The effect of this discovery was a loan default and a subsequent further reduction in the price of homes. This destroyed the mortgage-backed securities making companies write off their assets since they did not have any value. The orientation crippled the mortgage market. In real expressions, the point at which the housing bubble turned into crisis was the constant rates of income when in real terms the prices of houses were increasing at a faster pace.
The effect of the subprime mortgage on the banking sector
Declining prices of homes with increasing interest rates made borrowers default paying their loans causing the mortgage industry to cave in. The lenders in the subprime industry were adversely affected as investor confidence declined steadily. Furthermore, Instability in the financial market was caused by the depression of collateralized debt obligation. The credit crisis and mortgage industry have elicited varied economic views on how it caused the recent recession experience in the world. It is imperative to note that Banks are vulnerable to risks emanating from the financial crisis. Some of these risks are related to overdrafts and the risks to credit where those who borrowed fail to pay their financial obligation (Muolo, 10). Interest rates that form the backbone of banking institutions may rise during the financial crisis. This makes banks pay more for the deposits while on the other hand receipts from loans are less. The subprime home mortgage industry affected other industries like the home building plan which slowed down to nearly a stop.
During the financial crisis, many banks collapsed or merged to ensure their continuity in the market. In a study by Muolo (15), the ‘banking industry had to borrow an excessive amount of money as compared to their equity capital an event which made them highly leveraged and inclined to unpredictable market conditions’. Banks like the Lehman Brothers went bankrupt while others merged. In the same context, governments pumped in funds in form of the bailout plans. This monetary policy has the effect of increasing money in circulation and subsequent generation of demand. With an aim of stabilizing the financial markets, depository banks creatively used innovative products such as structured investment vehicles to evade ratios (i.e. capital ratios).
Muolo, Paul., & Padilla, Matthew. Chain of Blame. How Wall Street Caused the Mortgage and Credit Crisis. Hoboken, NJ: John Wiley and Sons, 2008.